Conflicted behavior (self-dealing): The Duty of Loyalty | Holger Spamann | December 07, 2017


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Conflicted behavior (self-dealing): The Duty of Loyalty

Original Creator: Holger Spamann Current Version: Holger Spamann Show/Hide

(Minority) Shareholders' interests are most at risk in transactions between the corporation and its controllers, be it management or large shareholders. The risk is obvious: the controllers may attempt to extract a disproportionate share of the corporation’s value for themselves, at the expense of (minority) shareholders.*

Some (not so) fictitious examples

Here are three typical ways controlling shareholders do it. I will illustrate using a fictitious oil company, OilCo, with a controlling stockholder, Mikhail. Mikhail owns 50% of OilCo, and 100% of another fictitious company, Honeypot.

1. The first thing Mikhail can do is to have OilCo sell its oil to Honeypot at below-market prices. For example, if the market price of oil is $16 per barrel, Mikhail might arrange for OilCo to sell its oil to Honeypot for $10. For every barrel of oil, this redistributes $3 from minority shareholders to Mikhail. Why? Because if OilCo had sold its oil on the market instead, it would have received $16 per barrel. These $16 would have been shared equally between Mikhail and the minority shareholders. Each would have received $8. But when OilCo instead sells to Honeypot for $10 per barrel, minority shareholders get only $5 (half of $10). The difference of $3 is captured by Mikhail: per barrel of oil, he gets $5 as a shareholder of OilCo and $6 as the sole shareholder of Honeypot (because Honeypot buys for $10 and sells for $16, generating a $6 profit), or a total of $11. The use of artificially inflated or deflated prices to shift value from one company to another is called a transfer pricing scheme. It is also used for tax avoidance purposes.

2. Mikhail can also have OilCo issue new shares to himself or to Honeypot at low prices. For example, imagine that OilCo owns oil fields worth $100 million, and that OilCo has one million shares outstanding. That means each share is worth $100 (assuming no transfer pricing scheme), and Mikhail’s 50% stake and the 50% minority shares as a group each comprise 500,000 shares worth $50 million in total. Mikhail now has OilCo issue 100 million shares to himself at $0.01 per share for an overall price of $1 million. This means three things. First, OilCo is now worth $101 million: In addition to the $100 oil field, it now has the $1m that Mikhail put in for the new shares. Second, Mikhail now owns almost the entire company, owning 100.5 million out of 101 million shares (99.5%). Third, the transaction earned him $49.5 million: Before the transaction, Mikhail owned OilCo shares worth $50m (50% × $100m). After buying the new shares, Mikhail now owns shares worth $100.5m (99.5% × $101 million). Thus, Mikhail spent $1m to increase his OilCo holding by $50.5m ($100.5m – $50m), generating a pure profit of $49.5m ($50.5m – $1m). Mikhail’s gain is the minority shareholders’ loss: they lost $49.5 million in this dilution of their share.

3. Finally, Mikhail can also dispense with the minority altogether by selling OilCo’s assets to Honeypot for a low price. To wit, he could have OilCo sell its oil fields to Honeypot for less than their $100 million value. This is another transfer pricing scheme, but executed on OilCo’s productive assets rather than its products. As with other transfer pricing schemes, it can also be done in reverse: Mikhail could have OilCo buy an asset from Honeypot at an inflated price.

None of these schemes is fictitious at all. For example, they are stylized versions of what Mikhail Khodorkovsky and all the other Russian oligarchs are said to have done to the oil companies they came to control in Russia in the 1990s. Russian corporate law erected barriers to such self-dealing. But corrupt, scared, or just plain incompetent courts breached those barriers. It is a vivid illustration of the importance of the general “legal infrastructure” for the enforcement of corporate law. See generally Bernard Black, Reinier Kraakman, and Anna Tarassova, Russian Privatization and Corporate Governance: What Went Wrong?, 52 STAN. L. REV. 1731 (2000).

The U.S. approach

Now back to the U.S., where we nowadays take a functioning “legal infrastructure” for granted. What protections does it offer against minority expropriation?

First, public corporations must disclose all self-dealing transactions in an amount above $120,000 in their annual report (item 404 of the SEC’s Regulation S-K). Managers or a controlling shareholder may choose to not comply with this rule, but only at the risk of becoming the target of an SEC enforcement action.

The only provision of the DGCL that explicitly addresses self-dealing is DGCL 144. On its face, DGCL 144 merely declares that transactions between the corporation and its officers and directors are not void or voidable solely because of the conflict of interest, provided the transaction fulfills one of the three conditions in subparagraphs (a)(1)-(3). This statutory text implies that transactions not fulfilling either of these conditions are automatically void or voidable. But the text leaves open the possibility that some conflicted transactions might be void or voidable even though they do fulfill one of the three conditions of DGCL 144(a)(1)-(3).

Notwithstanding, Delaware courts do treat the three conditions as individually sufficient and jointly necessary for the permissibility of self-dealing by directors and officers. That is, self-dealing by officers and directors is beyond judicial reproach if and only if it has been approved in good faith by a majority of fully informed, disinterested directors or shareholders, or it is otherwise shown to be “entirely fair.” The courts do not derive this formulation from DGCL 144, however, but from “equitable principles.” Moreover, controlling shareholders are subject to more stringent review: their self-dealing is always reviewed for “entire fairness;” approval by a “well-functioning committee of independent directors” or by fully informed disinterested shareholders merely shifts the burden of proof (subject to the recent doctrinal-transactional innovation of Kahn v. MFW, covered in the M&A part of the course).

Before diving into the details of this self-dealing jurisprudence, consider a preliminary question: why permit any self-dealing? Delaware law can be characterized as an attempt to differentiate self-dealing that expropriates shareholders, from self-dealing that does not. It is likely that courts will make mistakes, however, and that some expropriation will slip through the judicial cracks.** Why not seal those cracks by prohibiting all self-dealing? The potential harm from self-dealing is great. What is the redeeming benefit, if any?


* There is nothing intrinsically wrong with “disproportionate” value sharing if “disproportionate” is measured against some extra-contractual standard such as equal dollar per person. Rather, what I mean by “disproportionate” here is disproportionate relative to the contractually agreed split.

** The transactions at issue in Sinclair (the oil sales), Weinberger, and Americas Mining below resemble the three Mikhail examples above. While they were ultimately caught, the controlling shareholders in these Delaware corporations must have thought they might get away with the expropriation. And sometimes, they arguably do, as in Aronson (which, viewed in a skeptical light, resembles the first Mikhail example above).


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  1. 1 Show/Hide More Guth v. Loft (Del. 1939) [Pepsi]
    Original Creator: Holger Spamann Current Version: Holger Spamann

    Guth is the mother of all Delaware duty of loyalty cases. The decision introduces the basic idea that it is incumbent on the fiduciary to prove that the fiduciary acted “in the utmost good faith” (or, in modern parlance, with “entire fairness”) to the corporation in spite of the fiduciary’s conflict of interest. As mentioned above, approval by a majority of fully informed, disinterested directors or shareholders can absolve the fiduciary or at least shift the burden of proof. In Guth, however, the Court of Chancery had found that Guth had not obtained such approval from his board.

    The decision deals with two separate aspects of Guth’s behavior. The corporate resources that Guth used for his business, such as Loft’s funds and personnel, clearly belonged to Loft, and there was little question that Guth had to compensate Loft for their use. The contentious part of the decision, however, deals with a difficult line-drawing problem: which transactions come within the purview of the duty of loyalty in the first place? Surely fiduciaries must retain the right to self-interested behavior in some corner of their life. Where is the line? In particular, which business opportunities are “corporate opportunities” belonging to the corporation, and which are open to the fiduciaries to pursue for their own benefit? Cf. DGCL 122(17). And why does it matter here, seeing that some of Guth's actions clearly were actionable self-dealing? Hint: Which remedy is available for which action?

  2. 2 Show/Hide More Sinclair Oil Corp. v. Levien (Del. 1971)
    Original Creator: Holger Spamann Current Version: Holger Spamann
    As we learned in Guth and will see in more detail in Weinberger, the standard of review for self-dealing — “utmost good faith” or “intrinsic fairness” or, nowadays, “entire fairness” — is demanding. It is, thus, extremely important to determine which transactions count as self-dealing. What is Sinclair‘s answer? Do you agree with it? May Sinclair's answer condone abuse of minority stockholders? What would happen if Sinclair had accepted the plaintiff’s broader view, not just in the short run but also in the long run (when a corporate group has time to restructure)?
  3. 3 Show/Hide More Weinberger v. UOP, Inc. (Del. 1983)
    Original Creator: Holger Spamann Current Version: Holger Spamann

    This decision introduces the modern standard of review for conflicted transactions involving a controlling shareholder.

    1. What is that standard of review, generally speaking?
    2. Can the controlling shareholder do anything to obtain a more favorable standard, or at least a more sympathetic application of the standard (cf. footnote 7)?
    3. How does the judicial treatment of self-dealing by a controlling shareholder compare to that of self-dealing by simple officers and directors (as described in the introduction to this section 2.2.1)?
    4. Does the harsher treatment of controlling shareholders make sense?

    Some terminology (for details, see the M&A section of the course):

    • Cash-out merger: A transaction in which some group of shareholders, generally minority shareholders, are “squeezed out” of the corporation. That is, they cease to be shareholders of the corporation in return for a cash payment, whether they like it or not. The name comes from the fact that the transaction is technically a merger between the corporation and some other corporation. The other corporation is usually a mere shell corporation, meaning it has been set up only for the merger and does not have any assets. While DGCL 251© requires shareholder approval for a merger, a simple majority vote is sufficient and hence minority approval is unnecessary. DGCL 251(b)(5) expressly allows conversion of existing shares into cash. Minority shareholders' only statutory remedy is an appraisal of the “fair value” of their shares under DGCL 262.
    • Tender offer: An offer to purchase shares addressed to all shareholders.

  4. 4 Show/Hide More Hypo: board service?
    Therein of Meinhard v. Salmon (NY 1928).

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